Deluxe Corporation
Q2 2014 Earnings Call Transcript

Published: 24 Jul 2014

[Operator:]

Good day, ladies and gentlemen, and welcome to Quarter 2 2014 Deluxe Corporation Earnings Conference Call. My name is Annette, and I will be your coordinator for today. [Operator Instructions] Please be advised, this conference is being recorded for replay purposes. I will now turn the conference over to Ed Merritt, Treasurer and Vice President of Investor Relations. Please proceed, sir.

[Ed Merritt:]

Thank you, Annette, and welcome, everyone, to Deluxe Corporation's Second Quarter 2014 Earnings Call. I'm Ed Merritt, Deluxe's Treasurer and Vice President of Investor Relations. Joining me on today's call are Lee Schram, our Chief Executive Officer; and Terry Peterson, our Chief Financial Officer. At the conclusion of today's prepared remarks, Lee, Terry and I will take questions from analysts. I would like to remind you that comments made today regarding financial estimates, projections and management's intentions and expectations regarding the company's future performance are forward-looking in nature as defined in the Private Securities Litigation Reform Act of 1995. As such, these comments are subject to risks and uncertainties which could cause actual results to differ materially from those projected. Additional information about various factors that could cause actual results to differ from those projected are contained in the press release that we issued this morning, as well in the company's Form 10-K for the year ended December 31, 2013. The financial and statistical information that will be reviewed during this call is addressed in greater detail in today's press release, which was furnished to the SEC on Form 8-K by the company this morning. The press release is also posted on our Investor Relations website at deluxe.com/investor. Any references to non-GAAP financial measures are reconciled to the comparable GAAP financial measures in the press release. Now, I'll turn the call over to Lee.

[Lee J. Schram:]

Thank you, Ed, and good morning, everyone. Deluxe delivered another very strong quarter, and we are well positioned as we enter the second half of the year to grow revenue for the year 3% to 4% despite a continued sluggish economic environment. We reported revenue and adjusted earnings per share in the second quarter above the upper end of our outlook. Revenue grew over 6% compared with the prior year quarter. Small Business Services revenue grew almost 9%. Financial Services revenue grew over 6%. Checks and forms performed well, and marketing solutions and other services revenues grew 20% over the prior year, and represented over 23% of total second quarter revenue. Adjusted diluted earnings per share grew over 5% from the prior year. We generated solid operating cash flow, and we were not drawn on our credit facility during the quarter, increasing our balance sheet cash position $26 million from last December. We announced the quarterly dividend increase of 20% in April and also repurchased $20 million in shares in the quarter, bringing our year-to-date repurchase total to $52 million. We continued our brand awareness campaign to help better position our products and services offerings and drive future revenue growth. We also advanced process improvements and slightly exceeded on our cost reduction expectations for the quarter. In a few minutes, I will discuss more details around our recent progress and next steps. But first, Terry will cover our financial performance.

[Terry D. Peterson:]

Thanks, Lee. Earlier today, we reported diluted earnings per share for the second quarter of $0.99, which included $0.02 per share for restructuring and transaction-related charges. Excluding these costs, adjusted EPS of $1.01 exceeded the upper end of our previous outlook, and was 5.2% higher than the $0.96 reported in the second quarter of 2013. Restructuring related charges are primarily for infrastructure consolidations and employee severance. Revenue for the quarter also exceeded the upper end of our previous outlook, coming in at $405 million, an increase of 6.3% over last year, or just over 3% excluding the impact of recent acquisitions. Small Business Services revenue of $274 million grew 8.7% versus last year, with approximately 6% growth in the quarter, excluding primarily the VerticalResponse acquisition from last year. While we continue to operate in a sluggish economic environment, we delivered growth in marketing solutions and other services, checks, and in our online, Safeguard distributor and dealer channels. SBS revenue also benefited from price increases implemented early in the first quarter. Financial Services revenue of over $88 million grew 6.5% versus the second quarter of last year. It would've declined less than 1%, excluding recent acquisitions. Price increases, higher marketing and other services revenue and revenue from HSBC more than offset the impact of lower check orders. Direct Checks revenue of $43 million was down 7.3% on a year-over-year basis, but ended ahead of our expectations. From a product revenue perspective, checks were $217 million, representing 54% of total revenue; business products were $94 million, or 23% of total revenue; and marketing solutions and other services were $94 million, which was 23% of total revenue. Gross margin for the quarter was 64.0% of revenue, which was down 1 point from 2013. Less favorable product mix and the increased material and delivery rates were only partially offset by benefits from price increases, improvements in manufacturing productivity and delivery initiatives. SG&A expense increased $9 million in the quarter, was better leveraged at 42.8% of revenue, compared to 43.1% of revenue in the same period last year. Benefits from our continuing cost-reduction initiatives in all 3 segments were offset by increased SG&A associated with recent acquisitions, and higher performance-based compensation and medical costs. Excluding restructuring-related charges, adjusted operating margin for the quarter was 21.3%, down from 22.1% in 2013. All 3 segments delivered strong operating margins. Small Business Services adjusted operating margin of 18.2% was down 0.6 percentage points over last year due to increased SG&A associated with acquisitions. Financial Services adjusted operating margin of 25.5% was down 1 point from 2013, due to higher expenses in acquisition and amortization associated with the Acton and Destination Rewards acquisition. Direct Checks adjusted operating margin of 32.3% increased 0.3 points from 2013, driven by better leverage and by expense management initiatives. Turning to the balance sheet and cash flow statement. We increased our cash and cash equivalents balance year-to-date by $25.8 million despite having repurchased $52 million of common stock through the first half of the year. Total debt at the end of the quarter was $646 million. Cash provided by operating activities for the first half was $125.8 million, a $23.7 million increase compared to the first half of 2013. The increase was driven primarily by changes in working capital, improved earnings and lower medical and performance-based compensation payments, partially offset by higher income tax payments. Capital expenditures for the first 6 months of 2014 were $19.9 million, and depreciation and amortization expense was $32.6 million. Given our strong results in the second quarter, we are raising our previous consolidated revenue outlook for the full year to range from $1.635 billion to $1.655 billion. We are increasing our expectations for adjusted diluted earnings per share to $4.04 to $4.14. There are several key factors that contribute to a stronger full year outlook, including

[Lee J. Schram:]

Thank you, Terry. I'll continue my comments with an update on our overall focus and then highlight progress in each of our 3 segments. I will also include throughout a perspective on what we hope to accomplish during the balance of 2014. Our primary focus in 2014 continues to be on profitable revenue growth and increasing the mix of marketing solutions and other services revenues towards our goal of 40% by 2018. As part of this revenue growth focus, we will continue to assess potential small- to medium-sized acquisition that complement our large customer bases with a focus on marketing solutions and other services. We have strengthened our channels in small business to include financial institutions, online, retail, wholesale, distributors, dealers and major accounts. Deluxe is now more capable of helping small businesses pursue their passion as a trusted provider of a growing suite of products and services to small business needs to market and operate their business, and helping small- to midsized financial institutions with customer acquisition, risk management and other value-added services. Here is an update on our 4 subcategories framework for marketing solutions and other services. We ended the second quarter right in line with our expectations in revenue, with mix in the 4 subcategories basically in line with our expectations. First, Small Business marketing is expected to represent approximately 41% in 2014, with expected growth in the high teens this year. We saw growth in the second quarter in the Web-to-print space as we cross-sold to our customer base and added new customers through distributors, dealers and major accounts. We will be introducing, in the third quarter, a new organically-built, automated business card and postcard production fulfillment system, which we believe will allow us to be more competitive in our Web-to-print channels. We also saw very strong double-digit growth in retail packaging solutions and expect this growth to continue in the second half of the year. The second category, Web Services, which includes logo and web design, web hosting, SEM, SEO, email marketing, social, payroll services, is expected to represent approximately 31% in 2014, with expected organic growth rate in the low double digits. We saw solid rollouts in both wholesale web telco, and SEM, SEO major accounts in the second quarter, and also solid growth from the prior year in cross-selling bundled present packages to our retail base and added more new customers, resellers and partners. We continue to be encouraged with sign-ups to paying customers so far for our new email marketing premium offer. We continue to reduce web design and SEM campaign cycle times, and churn rates remain low. We added payroll services customers and many customers added new features, such as time and attendance application. This category is also one of our key focus areas for tuck-in acquisitions. We closed the second quarter with approximately 805,000 web hosting customers, and we expect to close 2014 with nearly 850,000 web hosting customers, an increase of 16% from 2013, as we expect migrations to continue to ramp through the balance of the year. The third category, Fraud, Security, Risk Management and Operational Services, is expected to represent approximately 19% in 2014, with expected growth rates in the low-single digits. We had a solid second quarter, as we added [indiscernible] programmed services for new community banks and fraud and security offers for small businesses and direct to our consumers. In April, we released our Banker's Dashboard tablet solution which we expect will help secure new financial institutional wins throughout the balance of the year. We also saw additional orders from our Deluxe e-checks offer. Finally, other financial institution services are expected to represent approximately 9% in 2014, with expected growth rates in the very strong double digits. In the second quarter, we saw growth in new financial institution customers in targeting and campaign services and delivered on expected revenue from Destination Rewards. We also began piloting our enhanced SwitchAgent 2.0 release in the second quarter, which is our automated solution to help consumers switch banking service providers. We continued to expect marketing solutions and other services revenues to be approximately $400 million to $410 million in 2014, up from $343 million in 2013, with organic growth in the low-teens. If achieved, this performance would translate to a total revenue mix of around 25% of revenue, up from 22% in 2013, and 19% and 16% the previous 2 years. Here's an update on our brand awareness campaign. In late April, we finished our first wave of the year of an intense 6-week, local market brand awareness campaign targeting to Raleigh, North Carolina, and Columbus, Ohio, markets through television, online digital and print media. We saw very strong results in these 2 markets compared against other markets where we did not complete brand awareness initiatives. We expect to complete additional waves of brand awareness marketing in both the third and fourth quarters in other local markets at various spend level. As a reminder, our objective this year is to continue with our brand awareness campaign to targeted key audience small business segment, to test various spend levels and media initiatives in different geographies over approximately 6-week burst. By doing this, we are able to continue our transformational messaging as we gain a better understanding of how our customers react to different scenarios, allowing us to more effectively and optimally plan for 2015 and beyond. In the second quarter, we also participated in National Small Business Week with a successful media tour event, and participated in a small business Expo in New York City, where we received very positive feedback from small business customers. Now shifting to our segments. Small Businesses Services in the quarter, as expected, we did not see any notable improvement as the economic climate for small businesses remained sluggish. We had strong performance, however, as revenue grew almost 9%. Checks and forms met our expectations. Results from targeted customer segmentation in the call center improved. New customers from our financial institution, Deluxe Business Advantage referral program and our direct response campaigns remained strong. Visitor traffic, average order value and conversion rates increased. Our online, Safeguard distributor, dealer and major accounts channels grew revenue over the prior year. We also saw strong growth in web, email marketing and payroll services, as well as growth in SEM, SEO, and Web-to-print services. Again, we ended the quarter with approximately 805,000 web hosting customers. Here is an update on e-checks. In addition to paper checks, we continue to slowly see a ramp in selling e-checks to our current small business, core customer base. And we will be adding e-checks to our distributor, dealer and major account channels in the second half of the year. However, we are also seeing strong interest in many areas where we do not sell paper checks today. For example, several large financial institutions are assessing their use in treasury, commercial, online and lockbox areas, none of which we produce paper checks for today. Also companies that issue paper rebate, temporary staffing and other payment solution checks today are assessing e-checks, including several of these where we have pilots underway. It is still very early, and we continue to focus on building our customer and user awareness, as well as working through many operational, process and systems hurdles that exist in a very nascent, early market. But we remain optimistic in e-checks as a small business payments offer. We continue to closely monitor the small business market. Optimism indices increased in April and May, but as the quarter ended in June, there was a bit of a drop-off in optimism. Pessimism about the economy and the future moderated in the quarter. Sales expectations trended lower, exiting the quarter. More owners are planning to hire in the coming months, and more new firms are starting and failing right now. Small businesses continue to spend cautiously, more in maintenance mode, continue to scrutinize purchases and experience tight cash flow. In summary, current optimism indices, although still at recessionary levels, actually trended higher in the second quarter even with the pullback in June. The good news is that other than taxes and regulation, increasing sales continues to be a small business owners #1 pain point, and our portfolio is significantly more robust now with many offers to help them here. The economy recovers with the transformative changes we are making to deliver more services offerings that help small businesses get and keep customers. Deluxe is better positioned as an indispensable partner for growth. In SBS, our focus for 2014 is on accelerating our brand transformation and significantly improving overall market awareness, while institutionalizing our brand promise for our customers, creating an effective end-to-end, integrated technology customer experience, effectively acquiring and retaining customers and optimizing sales channels effectiveness and channel marketing capabilities. In Financial Services, we saw the check decline rate perform slightly better than our expectation, a little less than 6%, and we continue to expect the decline rate for the year will be about 6%. We had strong overall new acquisition rates, and our retention rates remain strong on deals pending in the current quarter, in excess of 90%. We simplified our processes and took complexity out of the business, while reducing our cost and expense structure. We have now extended all our large contracts through at least the third quarter of 2015, and now have extended contracts representing about 20% of our annual Financial Services revenue for 7 to 8 years. We also continue to work a number of competitive RFPs, and we are pleased to announce that we anticipate, starting in late September, the migration of Zion's bank, which is the new client that we referenced on our first quarter call. We made progress again in the quarter in advancing non-check market solutions and other services revenue opportunities. We now have offers in the targeting and campaign services space through ACTON and Cornerstone, to assist financial institutions with customer acquisition and retention, account activation and anchoring offering SwitchAgent, and now, an account activation and retention rewards and loyalty offer, in Destination Rewards. In the second quarter, we saw continued growth in new financial institutions in our ACTON and Cornerstone targeting and campaign services offers, and we introduced a new offering in the market

[Operator:]

[Operator Instructions] The first question comes from the line of Randy Hugen of Feitl.

[Randy L. Hugen:]

It looks like it might be growing faster than maybe you expected. Could you give us an information on the overall growth rate there? And then also, is that growth being driven by those large clients that you mentioned, or are there many other small clients that are also adopting that offering?

[Lee J. Schram:]

Randy, I missed the beginning of the -- you weren't coming through at the beginning of the question. Could you just repeat it?

[Randy L. Hugen:]

Sure, sure. Destination Rewards, is that growing faster than what you expected? How fast is it growing? And then also, could you give us some information on the type of clients that are driving that? Is that the large client that you mentioned in the script or are there other smaller clients that are all contributing to that growth?

[Lee J. Schram:]

Yes, right now, we clearly expected a ramp as we bought the company in December last year. So -- and we expected some of the pilots that they introduced, Randy, to become rollouts. So think of that as that was our ambition when we bought it and kind of what we planned for as the year unfolded. So we expected to see a ramp. I think the thing that's really interesting for us right now though is that we are starting to see some success and larger financial institutions that are committing to either pilots or rollouts at this point in time, and we're just getting started there. We've put a good program in place. We have a lot of interest in the rewards and loyalty space. And then, Destination Rewards always had customers in other non-financial Services markets, and we're just trying to opportunistically take advantage of that. I made a comment today about an opportunity we had of one of the largest insurance companies, and that's starting in the fourth quarter as well. So we think we're at the early stages of momentum here. But we had a ramp planned as we went -- as we bought the company. And clearly, we expect that ramp to happen in the second half of the year. And also extend into the 2015 from a ramp standpoint as well. So we're really excited about this, and we think there's a lot of potential. And we think it's a unique program, with the 0 liability program and something that's not out there in the market place today. So clearly, we are enthused with it.

[Randy L. Hugen:]

All right. And then, you've mentioned that you're seeing strong growth in email marketing. Gmail made some changes in their services a few months ago that seems to be impacting how frequently a customer has been using [ph] some promotional marketing email. Have you got any impact on that, on the rate in the past quarter?

[Lee J. Schram:]

No. The way to think about it is the opportunity for us here is with the new freemium offer that we've got out from our acquisition of VerticalResponse. We're early stages with the new footprint in the market. But I look at this and I see the results and week to week, Randy, we're seeing more and more sign-ups, first of all, and we see more and more conversions from the premium offer to actually paying customers. So at this point in time, we're seeing a ramp there, and we expect that ramp to continue.

[Operator:]

The next line of questions comes from the line of Tim Klasell of Northland Securities.

[Tim Klasell:]

Just to circle back on the Destination Rewards. I noticed that the MSO revenues weren't -- the guidance there wasn't raised, but the other revenues were. Are some of the big, new customers that you mentioned in the script, does this take a while for them to ramp up? How should we think about that, going forward?

[Lee J. Schram:]

Tim, it does. We left the range that we had of $400 million to $410 million, we raised the top end of the revenue, about $500 million, it came from non-NOS. But it does take a while to ramp. What happens is we -- sometimes a new bank or a Verizon, the example we gave, or the large insurance company, will start a pilot and then they'll roll out. And even when they do a full rollout, it can take time for a consumer to sign up for the various programs. So even though we're excited about it, what we have to be mindful of is what that ramp is actually going to look like. So we're just obviously trying -- we're learning. It's still a very new acquisition for us, but I don't want to signal that we feel all negative on it. It's just that the look -- the ramp curve is not something that we're used to at this point in time. And honestly, for DR, they are learning in some of these new markets, especially in the financial institution space as well.

[Tim Klasell:]

Okay, good. And then are you adding 50,000 or plan to add 50,000 new hosting customers, hosting sites. What's driving that? Is that new customers or is that existing customers expanding their usage?

[Lee J. Schram:]

No. These would be -- these are all new customers. So we either get them through accounts that we take over and migrate in, or we get them through accounts that we win and then they are basically on organic build. So they never had a telco or media small business offer, Tim, is the way to think about it. So what happens is that we basically add small business customers through what we call an organic program. It's coming from both.

[Tim Klasell:]

Okay, good. And then final question, you're adding new Web-to-print capabilities to bring down your cost, it sounds like. Exactly what are you doing there? And is the primary competitor there, Vistaprint?

[Lee J. Schram:]

They're the largest player in the market, as you know. But there's a lot of other competitors in the market, and we are really excited about this. Let me tell you what we try to do here, expand on that, a little more color on what I mentioned in the script. If you think about what we did for the common order fulfillment system, basically putting software and mechanical work technology behind how we ship in effect a box of checks or now a flat package of checks. We've done the same thing, and we've been working on this for a while now. But we created the same thing. So think of it as an ability to produce business cards and postcards at -- and I call it in a frictionless way where no human intervention. And I wish I could show you the video. We didn't put one out onto the release today, but I've seen it and it's getting ready, as I mentioned, to go into production this quarter. And we think it's going to allow us to get more -- get things through our systems and our process better and to your point, give us a cost reduction play as well. So really, a wonderful team of people that I have here in our Shoreview headquarters location or near the location have worked on this capability, and kudos to them for what we believe is going to be something exciting for the Web-to-print space.

[Operator:]

[Operator Instructions] The next line of question comes from the line of Charlie Strauzer of CJS Securities.

[Charles Strauzer:]

A couple of questions. Why don't we just kind of go on the gross profit line, if we could. I know it was a little bit lower year-over-year for the reason you mentioned. But as we look at to the second half of the year, Terry, can you give us a sense of the assumptions we should be using for gross profit versus maybe SG&A as a percent of revenue?

[Terry D. Peterson:]

Yes, in comparison to second quarter of last year, we're down about 1 point, and there was really a couple of things happening there, Charlie. There was a bit of an unfavorable mix coming through there, causing the margin to come down just a little bit. Also too, we have been seeing higher material and delivery rates coming through. And that's been a pretty consistent trend for the past couple of years, so that coming through is also impacting the margins there a little bit. And both of those factors, we would -- we did expect and would continue to expect those going forward, as we look ahead.

[Charles Strauzer:]

Is that mostly -- when you said delivery, is that mostly from the postal increase [ph] that just went through?

[Terry D. Peterson:]

Postal, we use the United States Postal Service. We also use UPS for a significant portion of our delivery in certain parts of the business. So it's a collective increase, across the whole platform.

[Charles Strauzer:]

And as we look out longer term, in terms of the operating income growth versus revenue growth, obviously it's kind of trailing right now. But do you think as you implement some of these additional clauses [ph] and stuff that you can see that trend more in line longer term?

[Terry D. Peterson:]

We -- what we've really stated right now is that we as a team are really committed to delivering growth in our earnings and that's through profitable revenue growth. But really, from a margin rate perspective, because we're still investing in the business, we really expect that the margin rate is going to be fairly flat over the foreseeable future. So again, our commitment is really on growing the earnings dollars, not so much the margin rate, as we go ahead. And then really get back to the level of investments that are offsetting some of the cost reductions that we continue to generate. But that's probably the best way to think about it for the foreseeable future.

[Lee J. Schram:]

And Charlie, I would like to add though that we still do expect to be able to, out into the kind of the strategic horizon, be able to grow our earnings per share at a faster rate than revenue because of the way we continue to manage the company, the transformation between our tax rates and our debt level. So you need to think about all that. But we don't want to underinvest now as we're starting to get some real nice scale, and we're just going to be -- we're going to stay after our cost reductions and keep the formula going here. And that's hopefully what we've been talking about, and we've been guiding in terms of people that are interested in the stock.

[Charles Strauzer:]

That's very helpful. And if I can circle back for a second on the PsPrint side. You mentioned, Lee, in terms of finding other products to offer your direct check customers, is there a plan to maybe integrate some of the PsPRint type of offerings into that type of strategy?

[Lee J. Schram:]

Yes, I'll talk a little bit more as we get into the third quarter about where we're going with this, what I mentioned this integrated technology customer experience. I prefer to not make a lot more comments on that. I know there's a lot of my competitors are out there and wondering what we're talking about here. But the best I can tell you right now is think of it as a way for a customer to come in and get with -- intuitively and simply, add our services and add our print offers in a just lot easier way than the way we do it today from all of these acquisitions that we've done over time. It's got really cool technology that my team is working on, and we're excited about it. I think it's a little early to spend a lot more color on it, but as we get into the balance of the year, similar to what I did today on e-checks, and we'll be talking a little bit more about Destination Rewards, I'll try to get some more color on that as well, Charlie.

[Operator:]

Thank you for your questions. I would thank you for all your questions, ladies and gentlemen. That now concludes the question-and-answer session. I would now like to turn the conference over to Lee Schram for closing remarks. Thank you.

[Lee J. Schram:]

Thanks, Annette, and thanks, everybody, for your participation and for your questions today. I'd just like to summarize the quarter in 3 points

[Ed Merritt:]

Thanks, Lee. Before we conclude today's call, I'd like to mention that the Deluxe management will be presenting in a few upcoming conferences in the second -- in the third quarter where you can hear more about our transformation. On August 5, we will be in New York City at the Needham Interconnect Conference. On August 6, we will be at an investment conference in Minneapolis. And on September 16, we'll be in New York at the Credit Suisse Small Cap Conference. Thank you for joining us, and this concludes the Deluxe second quarter 2014 earnings call.

[Operator:]

Thank you. Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a good day. Thank you.