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Executives

Jeff Johnson - Vice President of Investor Relations and Treasurer

Lee J. Schram - Chief Executive Officer and Director

Terry D. Peterson - Chief Financial Officer and Senior Vice President

Analysts

Charles Strauzer - CJS Securities, Inc.

Deluxe (DLX) Q1 2013 Earnings Call April 25, 2013 11:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Q1 2013 Deluxe Corporation Earnings Conference Call. My name is Allison, and I will be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes.

I'd now like to turn the call over to Mr. Jeff Johnson, Treasurer and Vice President of Investor Relations. Please proceed, sir.

Jeff Johnson

Thank you, Allison. Welcome to Deluxe Corporation's 2013 First Quarter Earnings Call. I am Jeff Johnson, Deluxe's Vice President of Investor Relations and Treasurer. Joining me on the call today are Lee Schram, Deluxe's Chief Executive Officer; and Terry Peterson, Deluxe's Chief Financial Officer. Lee, Terry and I will take questions from analysts after the prepared comments. At that time, the operator will instruct you how to ask a question.

In accordance with Regulation FD, this call is open to all interested parties. A replay of the call will be available via telephone and Deluxe's website. I will provide instructions for accessing the replay at the conclusion of our teleconference. Before I begin, let me make this brief cautionary statement.

Comments made today regarding financial estimates and projections and any other statements addressing management's intentions and expectations regarding the company's future performance are forward-looking statements 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 news release that we issued this morning and in the company's Form 10-K for the year ended December 31, 2012. In addition, the financial and statistical information that will be reviewed during this call is addressed in greater detail in today's press release, which is posted on our Investor Relations website at deluxe.com/investor, and was furnished to the SEC on a Form 8-K filed this morning. In particular, any 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, Jeff, and good morning, everyone. Deluxe delivered an outstanding quarter to start the year. We reported revenue and adjusted earnings per share above the high end of our outlook. Revenue grew almost 3% over the prior year quarter, even though there were 2 less business days compared to last year. Small Business Services' revenue grew 8%. Checks and forms both performed better than our expectations, and marketing solutions and other services revenues grew 22% over the prior year.

Adjusted diluted earnings per share grew 3% over a very strong 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 $25 million from last December. And we repurchased $13 million in shares.

We continued our new brand awareness campaign to help better position our products and services offerings and drive future revenue growth. We also advanced process improvements and delivered on our cost reduction commitment in 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

Thank you, Lee. Earlier today, we reported diluted earnings per share for the first quarter of $0.89, which included losses of $0.02 per share from restructuring charges. Excluding these costs, adjusted EPS of $0.91 exceeded the upper end of our outlook and was 3.4% higher than the $0.88 reported in the first quarter of 2012. The restructuring charges are primarily for employee severance and infrastructure consolidations.

Revenue for the quarter came in at $388 million and grew 2.5% over last year despite 2 less business days compared to the first quarter of 2012. All 3 of our business segments performed well.

Small Business Services' revenue of $248 million grew 8.1% versus last year on a reported basis but is double digits when considering 2 less business days. While we continue to operate in a weak economic environment, we delivered growth in marketing solutions and other services, checks and in our online Safeguard distributor, major accounts and dealer channels.

Financial Services' revenue of $87 million declined 3.8% versus last year but was close to flat when considering 2 less business days. The impact of lower check orders offset the benefits of price increases and higher marketing solutions and other services revenue.

Direct Checks' revenue totaled $52 million, which was down 9.9% on a year-over-year basis. This segment was also negatively impacted by 2 less business days. Gross margin for the quarter was 65.6% of revenue, which was down 0.7 points from 2012. Unfavorable product mix and increased material and delivery rates were only partially offset by benefits from price increases and improvements in manufacturing productivity and delivery initiatives.

SG&A expense increased $3.3 million in the quarter and was 45.2% of revenue compared to 45.5% of revenue in the same period last year. Increased SG&A in Small Business Services associated with commissions on increased revenue, higher brand awareness spending and the OrangeSoda acquisition, was partially offset by benefits from our continuing cost reduction initiatives in all 3 segments.

Excluding restructuring charges, adjusted operating margin for the quarter was 20.4%, which was down 0.7 points from the 21.1% generated in 2012, but slightly better than our expectations. All 3 segments delivered strong operating margins compared to expectations.

Excluding restructuring charges, Small Business Services' operating margin of 15.8% was down 1.6 percentage points over last year due to higher SG&A, driven primarily by higher brand awareness spending. Financial Services' operating margin of 26.8% was up 2.6 points from 2012 due to a price increase, better product and services mix and cost reductions. Direct Checks' operating margin of 31.5% increased 0.2 points from 2012 as we continue to realize plant synergies from integrating Custom Direct.

Turning to the balance sheet and cash flow statements. We increased our cash and cash equivalents balance by $25 million despite repurchasing $13 million of our common stock to offset expected dilution from employee plans. Total debt at the end of the quarter was $651 million, basically flat from the end of 2012. Cash provided by operating activities was $51.5 million, about the same as 2012. Compared to last year, lower contribution to fund future medical benefits, as well as lower contract acquisition and income tax payments were basically offset by higher variable compensation earned in 2012 but paid out in the first quarter of 2013. Capital expenditures for the quarter were $8 million, and depreciation and amortization expense was $16 million.

We are tightening our consolidated revenue to the upper end on a full year basis to a range of $1.545 billion to $1.575 billion. Our strong performance in the first quarter is expected to be mitigated by an unfavorable impact from recent trends in the Canadian exchange rate.

Diluted earnings per share has been tightened to the upper end as well, to an expected range of $3.65 to $3.80. There are several key factors that contribute to our full year outlook, including: Small Business Services' revenue is expected to increase in the high-single-digits range as volume declines in core business products are expected to be offset by benefits from our e-commerce investments, price increases, our distributor, dealer and major accounts channels and double-digit growth in marketing solutions and other services offerings; we expect Financial Services' revenue to decline in the mid-single-digits range, driven by recurring check order declines of approximately 5% to 6% and some pricing pressure, which we expect will be partially offset by continued growth from non-check revenue streams and price increases; Direct Checks' revenue decline in the mid- to high-single digits, driven by check volume reductions, a continued sluggish economy, additional cost and expense reductions, increases in material and delivery rate, continued investments in revenue growth opportunities, including brand awareness, marketing solutions and other services offers and enhanced Internet capabilities, lower interest expense and an effective tax rate of approximately 34%.

We expect to continue generating strong operating cash flows, ranging between $240 million and $255 million in 2013, reflecting stronger earnings in the mid to upper end of our outlook and lower Viva payments for future medical costs, offset by higher income tax and incentive compensation payments. We expect contract acquisition payments to be approximately $15 million.

2013 capital expenditures are expected to be approximately $35 million, roughly the same as 2012. We plan to continue to invest in key revenue growth initiatives and make other investments in order fulfillment and IT infrastructure.

Depreciation and amortization expense is expected to be $62 million, including $15 million of acquisition-related amortization. For the second quarter of 2013, we expect revenue to range from $375 million to $382 million. Diluted earnings per share are expected to range from $0.85 to $0.90. In comparison to the first quarter, revenue and adjusted EPS are expected to be slightly lower in the second quarter, primarily due to lower financial services and Direct Checks revenue and the resulting operating income.

Shifting to our capital structure, we expect to maintain our balanced approach of investing organically and through small- to medium-sized acquisitions in order to drive our growth transformation. We also expect to maintain our current dividend level and repurchase shares to offset dilution.

To the extent we generate cash flow in excess of these priorities, we plan to accumulate cash in advance of our 2014 senior note maturity. We may also from time to time consider retiring outstanding debt through open market purchases, privately negotiated transactions or by other means. We believe our strong cash flow, strengthened balance sheet and flexible capital structure position us well to continue advancing our transformation.

I will conclude my comments with an update on our cost and expense reduction initiatives. Overall, we had a solid start to 2013 in the first quarter as we delivered on our expected cost and expense reductions towards our $50 million commitment net of investments in 2013. Our focus in sales and marketing for 2013 is on sales channel optimization, platform and tool consolidation and leveraging order streaming and marketing efficiencies. We also expect to continue improving the mix of paper catalog and online search engine marketing.

In fulfillment, we are continuing to focus on our lean, direct and indirect spend reductions, further consolidating our manufacturing technology platforms, driving delivery technology and process efficiencies, reducing spoilage, further enhancing our strategic supplier sourcing arrangements and continuing with other supply chain improvements and efficiencies.

Finally, for Shared Services' infrastructure, we expect to continue reducing cost in IT and other areas as more opportunities exist to improve efficiencies.

Now I'll turn the call back to Lee.

Lee J. Schram

Thank you, Terry. I will 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 2013.

Our primary focus in 2013 continues to be profitable revenue growth and increasing the mix of marketing solutions and other services revenues. We have created more differentiated, technology-led check offers through investments in automated flat packaging, digital printing and online portals and dashboards. We also have significant growth opportunities in marketing solutions and other services. We will continue to assess potential small- to medium-sized acquisitions 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 of small business needs to market and operate their business, and helping small to mid-sized financial institutions with customer acquisition, risk management and other value-add services offers.

Here is an update on our 4 subcategories framework for marketing solutions and other services. We ended the first 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 42% of revenue in 2013, with expected growth in the upper-teens this year. We saw strong double-digit growth in the first 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. The second category, web services, which includes logo and web design, web hosting, SEM, SEO, email marketing, social and payroll services, is expected to represent approximately 32% of revenue in 2013, with expected organic growth rates in the mid-teens.

We saw a little slower rollout in both wholesale web telco and SEM, SEO major accounts in the first quarter than expected from the $15 million of deals closed in 2012, which we expect will roll out throughout 2013. We saw growth from the prior year in cross-selling bundled presence packages to our retail base and added more new customers, resellers and partners.

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 applications. This category also is our focus area for tuck-in acquisitions.

We closed the first quarter with approximately 565,000 web hosting customers, and we expect to close 2013 with nearly 750,000 web hosting customers, or up 36% from 2012, as we expect migrations to ramp through the balance of the year. The third category, fraud, security and risk management services, are expected to represent approximately 22% of revenue in 2013, with expected growth rates in the high-single digits.

We had a stronger-than-expected first quarter as we added program services for new community banks and fraud and security offers for small businesses and direct to our consumers. We added Banker's Dashboard customers as well.

Finally, other financial institution services are expected to represent approximately 4% of revenue in 2013, with expected growth rates in the high-single digits. Key growth initiatives here include adding new Cornerstone and SwitchAgent clients.

We continue to expect marketing solutions and other services revenues to be approximately $330 million to $340 million in 2013, up from $285 million in 2012, with organic growth in the mid-teens. If achieved, this performance would translate to a total revenue mix of around 22% of revenue, including a year-end exit run rate above 25% of revenue towards our 25% mix goal and up from 19% in 2012 and 16% and 13% the previous 2 years.

Our new brand awareness campaign was in market throughout the first quarter. We continue to run the 3 television commercials we started in late 2012 during the first 5 weeks of 2013, then paused for about 6 weeks as planned, and then ran them again for 4 weeks through mid-April. We also continued print and digital online ads during these same timeframes. This media will continue at various times through the balance of 2013 and focused first. For competitive reasons, we will not disclose investment levels other than to indicate that it is a multimillion-dollar campaign, and all planned spending is included in our current outlook ranges.

We have established return-on-investment criteria based on the number of impressions, expected site visits and online leads. We will use results against these metrics to guide us as we progress on this new brand journey. It is important to remember that this campaign is primarily focused on improving brand awareness and not a targeted direct response campaign.

Here are some metrics we are seeing so far in the campaigns. Online click-through rates are over 50% above representative benchmarks. Traffic to deluxe.com is up over 20%. YouTube views of the 3 commercials are now approximately 900,000, and we are closing new business both online and in our dedicated call centers. The calls we are receiving are some of our most relevant and best converting lead sources.

Now shifting to our segments. In Small Business Services in the quarter, as expected, we did not see any notable improvements as the economic climate for small businesses remain sluggish. We had strong performance as revenue grew 8%, even with 2 less business days in the quarter. Checks and forms performed above our expectations. Our results from targeted customer segmentation in the call center improved. New customers from our financial institution, Deluxe Business Advantage referral program, and through our direct response campaigns, remain strong. Response rates, average order value and conversion rates improved. Our online Safeguard distributor and dealer channels grew revenue over the prior year. We also saw strong growth in web, SEM and payroll services. Again, we ended the quarter with approximately 565,000 web hosting customers.

We continue to closely monitor the small business market. Optimism indices increased slightly in January, ramped in February, but plunged in March and remained in recessionary territory with no indication of a surge in business confidence. Current levels are among the lowest levels in nearly 40 years. 77% of business owners expect business conditions over the next 6 months to be the same as they are now or worse. More owners are planning to reduce employment than hire in the coming months, and more plan to reduce inventories than plan to order new stocks. They continue to spend cautiously, more in maintenance mode, scrutinize purchases and experience tight cash flow.

In summary, current optimism indices have been trending downward over the past year and remain in recessionary levels. The good news is that other than taxes and regulation, increasing sales continues to be a small business owner's #1 pain point, and our portfolio is significantly more robust now, with many offers to help them here. As 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 that indispensable partner for growth.

Our focus for 2013 is on: accelerating our brand transformation and significantly improving overall market awareness while institutionalizing our brand promise for our customers, profitably integrating and extending our marketing solutions and other services portfolio, effectively acquiring and retaining customers across multiple channels, building a more effective retail services sales model, scaling major accounts and strategic channel partner relationships and improving our customer experience.

In Financial Services, in the first quarter, we saw a secular check decline rate of about 4%, which was better than our outlook of 5% to 6%, driven by strength in both the national and community segments. We had strong overall new acquisition rates, and our retention rates remained strong on deals pending in the current quarter, well in excess of 90%.

We are pleased to report that we were informed that we won a new national competitive RFP that we expect to migrate to Deluxe in the third quarter this year. This new business is expected to help offset the expected negative impact from foreign exchange in Small Business Services.

We are also beginning to work several more competitive opportunities. We simplified our processes and took complexity out of the business while reducing our cost and expense structure. Even though the first quarter secular decline rate was about 4%, we are prudently planning for check units to remain within a declined range of around 5% to 6% in 2013 for the balance of the year. We also expect retention rates in excess of 90% on deals pending this year. And with approximately 40% of our 2013 community bank contract renewals already completed by the end of the first quarter, we are well ahead of the linear pace for the year. As a reminder, we also implemented a price increase at the start of the year.

We made progress again in the quarter in advancing marketing solutions and other services revenue opportunities. Revenue grew over last year in these non-check services, which include customer acquisition, risk management and other profitability offers. In customer acquisition, and specifically our Cornerstone direct marketing analytics offer, we saw continued growth in new financial institutions. We started an all-branch rollout with a large financial institution for our SwitchAgent offering and will begin in the second quarter several additional nice-sized branch rollouts with other large financial institutions.

We continue to believe it will be an important tool for banks beyond acquisition to anchoring profitable clients. Financial institutions that use SwitchAgent are realizing a more profitable new account base due in part to the role of SwitchAgent in activating key payment services.

Banker's Dashboard also continued to perform well in the first quarter. As you can see, although not as fast as we had hoped in some areas, momentum continues to build, and we expect strong double-digit growth in these marketing solutions and other services in 2013.

In Direct Checks, revenue was basically in line with our expectations, driven by strong revenue per order and strong Custom Direct accessories revenue. We continue to look for opportunities to provide accessories and other check-related products and services to our consumers. Although we have made significant progress with the Custom Direct integration, we are still working a number of initiatives to create an integrated, best-in-class direct-to-consumer check experience. We continue to see a ramp in revenue enhancement synergies through our call center scripting and upsell capabilities, as well as synergistic costs and expense reduction.

For 2013, we expect Direct Checks' revenue to decline in the mid- to high-single digits, driven by continued declines in consumer usage in a sluggish economy. We expect to reduce our manufacturing cost and SG&A in this segment and hold our operating margins in the 30% range while generating strong operating cash flow.

As we exit the first quarter on the heels of a strong quarterly performance in a continued sluggish economy, we have made tremendous progress in transforming Deluxe. But we still have many opportunities ahead of us in 2013. Our strong first quarter positions us well to grow revenue in 2013 for the fourth consecutive year. We are conservatively not expecting the economic climate to improve throughout the balance of the year until we get better clarity as the year unfolds more. If the economy improves, we should have upside in revenue. At the same time, we will not take our eyes off the cost reductions and process improvements, and we expect to generate strong cash flows and provide a very attractive dividend. We have developed a strong platform for long-term growth with the objective of transforming Deluxe to more of a growth services provider from primarily a check printer, thereby changing our product mix and resulting stock price multiple.

And now, Allison, we'll let you open the lines up, and Terry, Jeff and I will take questions.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Charles Strauzer of CJS Securities.

Charles Strauzer - CJS Securities, Inc.

Two quick questions on -- thanks for all the transparency, by the way, on the various pieces there. But if you look at the organic growth of the quarter -- I know you gave out some of the segment information on a kind of apples-to-apples, normalizing up the different days. But what was the overall organic growth if you do the same?

Lee J. Schram

I don't know that we -- I don't know that I know that, Terry. Do you have that number?

Terry D. Peterson

The organic growth? The only piece that's not organic this quarter is a little bit from the OrangeSoda acquisition from last year. It's not significant at all. Most of the growth is all organic. In the Small Business Services segment, we had growth of 8.1%. It's still north of 5% for that segment, if you were to just look at the organic piece.

Jeff Johnson

And, Charlie, another marker out there for you, I think the number that we calculated with 2 -- with the -- if the 2 days were comparable was a 5.6% growth for the quarter. So we would have been slightly under that on an organic basis, but not a lot. It would have been very strong on an apples-to-apples compare.

Charles Strauzer - CJS Securities, Inc.

So still very good in the -- nevertheless?

Jeff Johnson

Very good. We're very pleased.

Charles Strauzer - CJS Securities, Inc.

And then on the new contract that you won, I know you can't give out too many details obviously yet. But could you maybe rank it in terms of the type of client it is versus maybe some of your other clients in terms of -- was it medium, large? Or is it kind of the upper end of your contract range? Or can you give a little bit more color there?

Lee J. Schram

Again, we're really excited about it. Hopefully, at some point here, we'll be able to release the logo. It's a well-known logo. And I would say it's a -- again, it's a nice-sized national opportunity for us. So we're not going to obviously get a whole year's worth of revenue from it. It will -- right now, the timing, as I said in my comments, Charlie, is in the third quarter. But we are really excited about it. I think when we get the logo out there, I think it'll put some excitement on our company, and I think it'll put some excitement out on the street.

Terry D. Peterson

Yes. The other thing, too, Charlie, is when we do start producing checks for them, that will benefit both our Financial Services segment, as well as the Small Business Services because they will be going after the DBA, Deluxe Business Advantage program as well. So it'll actually benefit both segments.

Lee J. Schram

Yes, that's a great additional comment. Charlie, one of the things we like about this financial institution is they have a very strong focus on small businesses. And again, as you know, that's a key focus area for us as well. So we just think it's a great match with us and this new institution.

Operator

We have no further questions at this time, so I'd now like to turn the call back over to Lee Schram, CEO.

Lee J. Schram

Wow. Only one question. Okay. So let me just close with thanking everybody for participating. And as I normally say, we're going to roll up our sleeves, get back to work, and we look forward to providing another positive progress report on our next call. And I'll turn it over to Jeff for some closing housekeeping.

Jeff Johnson

Thank you, Lee. This is a reminder that a replay of this call will be available until May 9 by dialing (888) 286-8010. When instructed, provide the access code 33314252. The accompanying slides are archived in our Investor Relations website at www.deluxe.com/investor.

Again, thank you for joining us. Have a great afternoon.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect, and good day.

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